The two schemes both offer immediate income tax relief (at a rate of 30%) on the amount invested, and in both cases any capital gain when the investment is realised is tax free. The tax reliefs can be summarised as follows:
Income tax relief at 30%
On up to £500,000*
On up to £200,000*
Must hold investment for
CGT exemption on disposal
CGT deferral (see below)
Business property relief for IHT
Yes (after held for 2 years)
Tax free income from investment
* The limit is to increase to £1million for both schemes after 5 April 2012, subject to EU approval. Note that the relief is limited to the amount of income tax you have actually paid in the tax year of your investment (or, in the case of the EIS, in that year and the previous one).
In the case of the EIS, you can defer any amount of capital gains (more than the £500,000 which is the limit of the income tax relief, if you wish) by investing the amount of the gain in an EIS company. The gain becomes chargeable when you cash in the investment, but can be deferred again if you reinvest in another EIS company.
Is This Available for Everyone?
The types of business which can qualify for EIS or VCT status are tightly defined, but this need not be your concern (unless you are being asked to invest in a friend’s business, in which case it may be possible to structure things in such a way that you qualify as an EIS investor). There are several providers in the marketplace who design specialised investment vehicles which qualify for these tax reliefs.
These investments have traditionally been regarded as “risky”, but there are now some products available which minimise the risks associated with investing in trading companies (which is essentially what both schemes involve).
Let us look briefly at a couple of the ways these schemes can be used in tax planning:
Cash Extraction from a Company
If your company has lots of cash which it does not need, the most tax efficient way to extract it is generally to pay a dividend, but if you are a higher rate taxpayer, you will have to pay income tax at an effective rate of 25% on the dividend, or 36.1% if you are a 50% income taxpayer.
Say you are a 40% taxpayer and you pay yourself a dividend of £100,000, and invest £83,333 of it in the EIS. You will have covered the tax on the dividend, and have £16,666 in your pocket. Assuming all goes well with the EIS company, in three years’ time you will get your £83,333 back, free of tax. There are some company owners who do this on an annual basis, and of course once they have been doing it for three years, they are getting £100,000 tax free each year (assuming they extract and invest £100,000 each year).
The annual limit of £50,000 on contributions to a pension scheme means that some people are looking at VCTs as an alternative. Although the tax relief is only 30% compared to the relief at your marginal rate of 40% or 50%, in practice, for most taxpayers, the rate of relief will be the same, unless they have a very large amount of income at the higher rates of tax. Looked at in the longer term, the rate of relief is actually higher in a VCT, because if you reinvest in another VCT after you get your money back in five years’ time, you get another 30% tax relief on the amount reinvested. And another point – income from the VCT is itself tax free, whereas a pension is taxable!
These are only a couple of examples of how the tax reliefs on the EIS and VCTs can be made to work for you. A good tax adviser will be able to come up with many others, and a good Independent Financial Adviser will be able to recommend which of the numerous schemes best suits your needs and your attitude to risk.
By James Bailey